[Economic Report of the President (1998)]
[Administration of William J. Clinton]
[Online through the Government Printing Office, www.gpo.gov]

[DOCID: f:erp_c7._]
Economic Report of the President - - - - - - - - - - - - H. Doc. 105-176
[From the online service of the the U.S. Government Printing Office]
[wais.access.gpo.gov]



CHAPTER 7 -- The Benefits of Market Opening

THE UNITED STATES HAS LONG RECOGNIZED that open domestic markets and
an open global trading system are superior to trade protection and
isolationism at promoting broad-based growth and prosperity. For
decades our open economy and successful U.S. leadership in
liberalizing global trade and investment have generated important
benefits for the American people, in the form of stronger growth and
improved employment opportunities. The opportunity to acquire goods
and services from abroad both encourages us as producers to stay
competitive and allows us as consumers to raise our standard of
living. In the 1990s, openness to trade and investment, combined with
U.S.-led liberalization of world markets, has been essential to our
economy's sustained expansion.

This contemporary picture of a prosperous America in an increasingly
open world economy contrasts powerfully with the economic climate and
international trade policies that prevailed at home and abroad some
six and a half decades ago. In the early 1930s widespread isolationism
had reduced world trade to a level only one-third that of 1929.
Fortunately the Nation's leaders of that era saw that the path of
economic isolation and tit-for-tat protectionism had no exit. During
the 1930s and after, the Administration and the Congress worked
together, through such measures as the Reciprocal Trade Agreements Act
of 1934, the precursor of later fast-track legislation, to revive
international trade, just as the programs of the New Deal worked to
restart the domestic economy. World War II disrupted these early
efforts, but after the war the U.S.-led campaign to open markets
worldwide enjoyed a series of outstanding successes. Those countries
that joined us in welcoming market opening, in particular through
participation in the General Agreement on Tariffs and Trade, have
grown and developed at impressive rates. True, these countries might
have experienced growth even without open markets, but the history of
this century has made it increasingly clear that strong growth is more
likely in open than in closed economies.

Bearing this history in mind, this Administration's strategy for
economic growth includes a campaign to foster the continued
liberalization of markets worldwide. Although much has been
accomplished in the postwar period, much remains to be done. As the
United States currently enjoys the benefits of relatively open markets
at home, this campaign reflects an export-driven agenda aimed at
opening markets abroad, reducing current asymmetries in countries'
openness. This chapter surveys the primary elements of this campaign.
It also reviews the impact that international trade has had on
national economies including our own and on the distribution of the
benefits of trade within economies (especially among workers). This
discussion underscores the need for a strong commitment to trade
liberalization not only by the United States, but by all of our
trading partners. The chapter concludes with a presentation of recent
developments in a second important dimension of open international
markets, namely, foreign direct investment, and discusses the
implications of the growth of U.S. direct investment abroad and of
foreign investment in the United States. The chapter begins, however,
with a review of recent trends in U.S. trade.

TRENDS IN U.S. INTERNATIONAL TRADE

The role of international trade in the U.S. economy today is
unprecedented. Until 1970, U.S. exports and imports combined rarely
amounted to more than one-tenth of gross domestic product (GDP; Chart
7-1). Since 1970, the real volume of trade has grown at more than
twice the rate of output, so that by 1997 exports alone were 12
percent of GDP, and imports were equivalent to 13 percent.

Yet trade remains a much smaller component of the U.S. economy than in
most countries: in 1995 only four countries had smaller ratios of



trade to GDP than the United States. This does not reflect high U.S.
trade barriers, but rather such factors as the size of our economy and
the diversity of our endowments, which favor self-sufficiency, and our
geographic location, relatively distant from most trading partners.
Estimates that adjust for such factors have often found that the
United States is more open to imports than are most other major
countries. But the point remains that the United States feels the
effects of trade and pressures for globalization much less than do
most other countries.

The rising importance of trade in the U.S. economy is part of a
worldwide phenomenon. Technological advances in transportation and
communications have contributed to a rapid expansion of the global
exchange of goods and services. There is also strong evidence that
policy reforms in many countries, in particular the removal of trade
barriers and other protectionist measures, have played a significant
role in this explosion of trade. The history of the United States
during the interwar period points to the importance of policy in
stimulating or inhibiting trade. In the years between 1920 and 1930,
technological progress continued, but policy moved in a different
direction: average U.S. tariff rates more than doubled. The fact that
the volume of trade in those years fell by half rather than rose
reveals the important role that government policies can play.

THE SECTORAL COMPOSITION OF U.S. TRADE

The composition of U.S. trade, both exports and imports, has also
changed markedly. Exports of services have enjoyed particularly strong
growth in recent years, rising from $48 billion (18 percent of total
exports) in 1980 to $237 billion (28 percent) in 1996. Over the same
period exports of agricultural merchandise have risen only from $42
billion (15 percent of the total) to $61 billion (7 percent). In part
these trends reflect Engel's law (as the incomes of households rise,
the share devoted to food falls) and the evolution of U.S. comparative
advantage in more skill-intensive goods and services. But the impact
of market opening may be discerned in these trends as well.
Innovations in global communications infrastructure and the
liberalization of services trade in many countries have promoted
greater trade in services. Large tariff reductions on manufactured
products, negotiated in a series of rounds within the General
Agreement on Tariffs and Trade (GATT), have lowered export costs in
that sector. However, agriculture remains relatively protected in most
countries.

Exports of both consumer and capital goods have enjoyed rapid
sustained growth since the 1980s (Chart 7-2). These two sectors also
represent the fastest-growing components of U.S. imports. But whereas
growth in exports of these goods has tended to occur relatively evenly
across industries, growth of imports has been more concentrated, with
especially dramatic increases in such categories as computer goods.



The fact that growth is occurring in both imports and exports of
consumer and capital goods may seem contrary to the conventional logic
of international trade theory, which is based on specialization
according to countries' comparative advantage. In fact, this trend
reflects the changing nature of trade. Imports and exports today often
grow in tandem even within very narrowly defined product categories:
that is, an increasing share of trade is intraindustry rather than
interindustry. In 1996, for example, 57 percent of U.S. trade occurred
within, rather than between, four-digit SITC commodity groupings (the
SITC is a standard classification of goods in international trade;
four-digit categories in this system represent highly disaggregated
product groups), and this share has risen from 51 percent in 1989.
Whereas interindustry trade (for example, the exchange of Chinese
sweaters for U.S. computers) is associated with traditional notions of
comparative advantage, intraindustry trade (for example, in
automobiles and auto parts) is thought to arise principally from fixed
costs in production and consumer tastes for variety.

THE GEOGRAPHIC COMPOSITION OF U.S. TRADE

Canada and Japan remain the United States' leading trade partners,
together accounting for one-third of both our exports and our imports.
In recent years Mexico and China have risen quickly to the third and
fourth positions; together they represent about 13 percent of total
U.S. merchandise trade. When trade is broken down by world region,
Europe represents one-fifth of both U.S. exports and imports (Chart
7-3). The Asia-Pacific region has experienced an explosion in growth
of both trade and output over the past two decades and now accounts
for more than one-third of total U.S. trade. This trade is principally
with other industrial countries, although trade with developing
economies in the region is also among the fastest growing anywhere.
Trade with Latin America and the Caribbean is also growing but remains
less than 10 percent of the total.



U.S. TRADE BY DOMESTIC REGION

In a country as large as the United States, the regional distribution
of the gains from trade is a relevant concern. The North Central and
Pacific States remain the largest sources of exports, and both regions
continue to enjoy strong export growth (Chart 7-4). However, the
highest rates of export growth have recently been recorded in regions
and States in the center of the country. This is a positive sign,
suggesting that the benefits of trade are being realized throughout
the country, not just in the coastal and border States. The impact of
the North American Free Trade Agreement (NAFTA) on regional trends in
production and exporting has no doubt been significant and may be
partly responsible for the rapid growth in exports from the Mountain,
Southern, and North Central regions. These statistics suggest that the
export opportunities presented by market-opening agreements can
benefit the Nation as a whole.



INITIATIVES IN MARKET OPENING

This Administration's primary focus in its conduct of international
economic relations is on the continued opening of markets worldwide to
trade. However, experience has shown that there is no universal
solvent for trade barriers: no single strategy works in all situations
to open foreign markets. Accordingly, the Administration has pursued
an active trade liberalization agenda on several fronts. While
recognizing the importance of an internationally coordinated effort to
reduce trade barriers on a broad multilateral and reciprocal basis,
the Administration is supplementing these negotiations with
liberalization efforts at the regional level. In addition, since
market access impediments may be peculiar to a single country, and may
not be of the type traditionally dealt with in a multilateral forum,
the United States sometimes needs to pursue bilateral negotiations to
remove these obstacles to trade.

As this brief survey shows, the Administration is pursuing greater
market access for both U.S. and other countries' exports in a number
of arenas. The importance of this undertaking is highlighted by the
extent to which large portions of the world economy have previously
been exempt from formal negotiations. Although the trade-liberalizing
initiatives described above are generally reciprocal in nature, they
tend to lower foreign barriers more than they do our own. This is the
result of the relatively open position taken by the United States
throughout most of the postwar period, which has resulted in U.S.
barriers that are already lower on average than those of our major
trading partners. What is more, the United States has led the way
toward the deregulation of domestic industries. In many cases this
earlier deregulation in the United States has produced highly
competitive U.S. industries, well poised to benefit from deregulation
abroad.

TRADE-NEGOTIATING AUTHORITY

The U.S. Constitution places ultimate authority to regulate
international trade with the legislative branch. However, for the
better part of this century the Congress has provided the executive
branch considerable authority to negotiate trade agreements with
foreign nations. Most recently, between 1974 and 1993, the Congress
repeatedly passed legislation giving the President so-called
fast-track negotiating authority. This legislation allows the
President to negotiate sensitive and complex trade agreements with
other countries, and commits the Congress to either accept or reject
the entire agreement, without amendment.  In this way the Congress
retains its constitutionally mandated final authority to regulate
international trade, while turning over the task of negotiating
agreements to the executive branch, which is organizationally better
suited for that role.

Fast-track authority lends credibility to U.S. commitments in trade
negotiations. Foreign parties to a trade agreement with the United
States know that the agreed-upon package cannot later be reopened for
renegotiation of individual provisions, which in effect would reopen
the entire package, undermining commitments made by executive branch
negotiators. In the absence of fast-track authority, this possibility
is real and can have the effect of preventing other countries from
engaging in negotiations with the United States.

The history of executive branch trade-negotiating authority has its
roots in the 1930s, a time when international trade flows were heavily
restricted by high tariffs throughout much of the world. The Congress
granted President Franklin D. Roosevelt power to negotiate tariff
reductions. This shift in authority came in the form of the Reciprocal
Trade Agreements Act (RTAA) of 1934, which allowed the President to
reduce U.S. tariffs on a bilateral basis by up to 50 percent in
exchange for reductions in barriers faced by U.S. exports. The RTAA
was used often in the 1930s and was repeatedly renewed. The resulting
agreements generated large reductions in tariff barriers and embodied
some of the same principles that formed the basis for GATT after World
War II and, more recently, the World Trade Organization (WTO).

Under the RTAA and later under GATT, tariffs of participating
countries were reduced from more than 40 percent in the 1930s to less
than 6 percent by the late 1980s. By the 1960s negotiations had
expanded to cover nontariff barriers (NTBs) to trade as well. These
include price controls, quantitative restrictions (such as import
quotas), and quality control measures. But because the RTAA provided
no authority to reduce these barriers, complications arose in
congressional ratification of the Kennedy Round GATT agreement in the
late 1960s. The Congress's refusal to implement the entire agreement
as negotiated undermined the credibility of the President's
negotiating efforts. The Nixon Administration confronted this problem
by pursuing expanded negotiating authority prior to undertaking a
round of negotiations in which nontariff barriers figured prominently.

For this reason, in 1974 the Congress passed the first fast-track
legislation. The primary difference between this new authority and
that granted under the RTAA was that fast-track extended presidential
authority to agreements covering NTBs as well as tariff barriers.
Fast-track bills have also generally called for extensive
consultations between the executive branch and both houses of the
Congress and with private sector advisory committees during the
negotiations. The Congress must also be notified in advance of the
intention to conclude an agreement. In return, the Congress promises
to introduce the implementing bill in both houses, with language
unchanged, and to vote on the unamended bill within 60 days. Through
these provisions, the Congress has historically exerted influence over
the negotiations_and hence over the resulting agreements_prior to
submission of the implementing legislation. Fast-track has thus proved
successful at facilitating negotiations while keeping the Congress
involved in the process and preserving its ultimate authority to
regulate trade.

Since the inception of fast-track, two extremely successful rounds of
GATT negotiations have taken place: the Tokyo Round, signed by WTO
members in December 1979, and the Uruguay Round, concluded in 1993 and
signed in April 1994. Agreements resulting from other negotiations
have also been approved by the Congress under fast-track procedures,
including the free trade agreement with Israel in 1985, the
U.S.-Canada Free Trade Agreement in 1988, and the North American Free
Trade Agreement in 1993.

MULTILATERAL INITIATIVES

By the conclusion of the Uruguay Round negotiations, participants
recognized that pursuing multilateral liberalization exclusively in
the context of negotiating ``rounds'' was insufficient. Thus, the final
Uruguay Round agreement included a ``built-in agenda'' for future, more
focused talks within the WTO. This agenda provides a mandate and an
opportunity to continue the liberalization process within the new
organization's regular work program. In some cases the built-in agenda
calls for the review and updating of the rules of the multilateral
system, including its dispute settlement mechanism (Box 7-1); in other
areas the goal is the further opening of markets and the reform or
elimination of practices that distort or restrict trade. In the few
years since the Uruguay Round agreement was concluded, negotiations
toward further liberalization have occurred_or are occurring_in
several sectors. Some of these negotiations were launched as a result
of commitments contained within existing WTO agreements. Others are
the result of forward-looking initiatives given impetus by the United
States and its trading partners within the Asia-Pacific Economic
Cooperation (APEC) forum and other international organizations.

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Box 7-1._The WTO Dispute Settlement Process and U.S. Trade Policy

The WTO Dispute Settlement Understanding (DSU), part of the Uruguay
Round package of agreements, improves on GATT dispute settlement
proceedings by expediting decisionmaking and instituting an appeals
process. It also establishes procedures to ensure the implementation
of dispute panel rulings, one of which is the acceptance of
cross-sector retaliation for countries that choose not to abide by the
ruling. In the 3 years since its institution, many countries have made
efficient use of the reformed dispute settlement mechanism, largely to
the satisfaction of all involved.

The introduction of a strengthened multilateral dispute settlement
system in the WTO, together with new WTO agreements covering the
protection of intellectual property rights and trade in services, has
brought about a shift in U.S. tactics for resolving trade disputes.
During the 1980s the United States frequently resorted to the
bilateral negotiations and unilateral sanctions authorized in Section
301 of U.S. trade law to resolve differences with other countries.
This approach was used in particular in the areas of agriculture,
intellectual property protection, and services, which GATT covered
barely or not at all. Beginning in 1995, however, the DSU and new WTO
rules have permitted the United States to use multilateral dispute
settlement procedures to address the overwhelming majority of issues
that have been the subject of Section 301 investigations. The results
of 35 complaints filed by the United States suggest that the DSU
process has proved very effective, with the United States prevailing
in 9 out of 10 rulings to date. The United States has also reached a
bilateral settlement prior to a formal ruling in eight cases.
Seventeen petitions are still pending. Section 301 investigations can
now more often make use of multilateral dispute settlement, at least
for disputes with WTO members in areas subject to WTO commitments. All
nine of the Section 301 investigations initiated during 1996, and
three of the six investigations initiated in 1997, have involved
resort to the WTO dispute settlement procedures; a fourth was
terminated before WTO consultations were initiated. As Chart 7-5
shows, the DSU process has been used against a variety of countries,
the majority of which are our major trading partners.
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The Success of Single-Sector Initiatives

The success of multilateral negotiations in the 4 years since the
Uruguay Round ended has in some ways been remarkable. The traditional
practice of conducting negotiations in comprehensive, multisector
rounds had been based on the belief that only an agreement covering
many sectors simultaneously could gain enough political support to be
viable. Usually when two or more countries seek reciprocal trade
liberalization, the easiest approach is to find one sector that is
heavily protected in one country and another sector that is heavily
protected in the other. By agreeing to liberalize both sectors
simultaneously, each country can please at least one group of domestic
producers.



However, recent WTO agreements in financial services,
telecommunications, and information technology represent significant
departures from this traditional negotiating format, in that each
sector was negotiated separately from the others. Because the United
States is believed to be highly competitive in all three of these
sectors, one would have thought that U.S. concessions in some other
sector would be necessary to reach an agreement. But a common element
in all three sectors is that they are key inputs into production in
other sectors, and are necessary for economic development and
profitable participation in an advanced, information-driven global
economy. Industrialists in emerging-market countries, for example,
understand that a modern telecommunications infrastructure is
essential to economic development. Hence, liberalization of these
sectors enjoys weighty domestic support in most countries, so that
cross-sector tradeoffs proved unnecessary. As transportation services
are also important inputs to trade and production in the modern global
economy, it is hoped that the future resumption of single-sector
negotiations in this area will bear fruit. Other sectors slated for
individual negotiation under the built-in agenda are agriculture and
government procurement.

Services

Two of the new WTO agreements_those in financial services and
telecommunications_deal with trade in service industries. For most of
its history GATT did not cover trade in most types of services. Thus
the conclusion of a new General Agreement on Trade in Services (GATS)
was an important contribution of the Uruguay Round. The new agreement
made it possible for the first time to undertake the negotiations that
led to the recent financial services and telecommunications
agreements, and should eventually lead to the liberalization of other
services.

GATS provides for the first time a solid framework of trading rules
and obligations for services and the continued expansion and
refinement of those rules in multilateral negotiations. However, the
pledges from WTO member countries within GATS itself to liberalize
their services sectors are fairly narrow in scope. Out of some 150
individual service activities identified, most countries have
committed themselves to liberalize fewer than 100. Moreover, most of
these commitments are in services where countries have either little
domestic production or little domestic protection. Although it is
typical in trade negotiations for countries to liberalize first where
the domestic impact is smallest, in this case it means that GATS as
written falls well short of comprehensive liberalization. This was
acknowledged by the signatories at the time. They therefore included
in the agreement specific deadlines for future negotiations in key
areas. Some success has been achieved in financial services and
telecommunications; the maritime negotiations, on the other hand, have
been suspended until more comprehensive services negotiations take
place in 2000.

Financial services. Multilateral negotiations on a broad range of
financial services resumed in April 1997. (An earlier attempt had
ended in 1995 with only an interim solution, as the United States had
found some other countries' offers inadequate.) In continuing these
negotiations, the United States emphasized the need for agreement on
four principles. Foreign-based firms should be assured of retaining
any rights they had acquired prior to the agreement, of the right to
establish new operations, of the right of full majority ownership, and
of substantially full national treatment (that is, legal and
regulatory treatment equivalent to that received by domestic firms).
These talks were successfully concluded on December 13 and produced
agreement among 102 WTO member countries on broad liberalization of
their banking, securities, insurance, and financial data services
sectors. The commitments apply to about $18 trillion in global
securities assets, $38 trillion in global bank lending, and about $2.2
trillion in worldwide insurance premiums.

Telecommunications. On February 15, 1997, the United States and 69
other WTO members successfully concluded negotiations on basic
telecommunications services, such as telephone service. The agreement
commits countries to provide market access and national treatment to
service suppliers from other WTO members. Sixty-five countries also
agreed to a set of specific procompetitive regulatory principles. The
agreement eliminates certain restrictive practices in countries that
account for 95 percent of world telecommunications revenues, estimated
at about $600 billion in 1996. Before the agreement, activities
representing only 17 percent of telecommu-nications revenues in the
top 20 markets were open to U.S. companies. The opening of these
markets to foreign providers offers enormous opportunities for U.S.
telecommunications firms. Whereas telecommunications markets in many
countries continue to be served by inefficient government monopolies,
markets in the United States have been largely deregulated.
Deregulation, along with a large internal market, has resulted in a
position of competitive advantage and technological leadership in this
area for U.S. suppliers.

Information Technology

Information technology products are often ``enablers'' for the efficient
production of goods in other sectors. Liberalization of this sector
therefore takes on added importance as a source of growth worldwide.
Concluded in Singapore in December 1996, the Information Technology
Agreement (ITA) will liberalize trade in this half-trillion-dollar
market. The agreement covers global information technology products
such as semiconductors, telecommunications equipment, computers and
computer equipment, and software. Signatories include countries
accounting for over 90 percent of trade in this sector. The agreement
also covers office machines and unrecorded electronic media (such as
computer diskettes and CD-ROMs). Each of the 43 participating
countries has agreed to eliminate tariffs on these  products by 2000,
although some countries were granted an extended phaseout of tariffs
for a limited number of products. The agreement will benefit all the
countries participating, but it is especially important for the United
States as a major exporter of information technology products. The ITA
also calls for further negotiations to extend country and product
coverage and eliminate NTBs under an expanded agreement, dubbed
ITA-II. These negotiations are scheduled to conclude by the summer of
1998.

Agriculture

Some agricultural tariffs were reduced in various GATT negotiations
over the decades, but as in the case of services, comprehensive
agricultural trade barriers only recently became a central focus of
GATT talks. The result was the historic Uruguay Round Agreement on
Agriculture, the first comprehensive agreement to reduce barriers to
trade in agriculture. Among other commitments, the agreement specifies
cuts in agricultural export subsidies, reduces aggregate support to
farmers, converts NTBs to tariffs, binds all tariffs at levels that
imply reductions in previously existing tariffs, and provides for
minimum access quotas for products whose trade had been largely
eliminated by past protection. Reflecting a general interest in
further liberalization, agricultural negotiations are a part of the
WTO's built-in agenda, with talks scheduled to resume by January 2000.

Government Procurement

Government procurement and contracting account for up to 15 percent of
economic activity in some countries, yet are often subject to policies
that discriminate against foreign suppliers. Many countries maintain
explicit preferences for goods and services provided by domestic firms
over those from foreign competitors. Bias toward domestic producers
can manifest itself in many other subtle ways, for instance in limited
advertising for bids and a reluctance to spell out selection criteria
in advance. Governments may also specify contracts in terms of a
certain process or method rather than in terms of the final product.
Different firms often develop products that serve the same purpose,
but by different processes. If only domestic firms use a particular
process, and foreign firms another, governments can in effect exclude
foreign suppliers by specifying that process.

Government procurement has historically been excluded from
international trade rules; the nondiscrimination principles contained
in the original GATT of 1947 do not apply. To address this situation,
a group of countries consisting principally of members of the
Organization for Economic Cooperation and Development (the OECD, which
is composed mainly of high-income industrial countries) negotiated the
1979 GATT Agreement on Government Procurement during the Tokyo Round
of multilateral trade negotiations. That agreement was renegotiated
and expanded during the Uruguay Round, and the resulting WTO Agreement
on Government Procurement (GPA) went into effect on January 1, 1996.
The GPA requires signatories to accord nondiscriminatory treatment to
the goods and services, including construction services, of other
signatories and to follow transparent government procurement
procedures. The agreement presently applies to government purchases
estimated to be worth over $400 billion annually.

Although the GPA was a significant achievement, only 26 countries
participate in it, most of them OECD countries; many of the world's
emerging markets in Asia, Latin America, and elsewhere are not
signatories. Given the size of the worldwide market (with an estimated
value over $3.1 trillion) and its importance for U.S. exporters, the
United States has long sought to extend rules on government
procurement to all participants in the multilateral system. Largely
at  the United States' urging, WTO members agreed in 1996 to establish
the WTO Working Group on Transparency in Government Procure-ment.
Formal negotiations are scheduled to begin by January 1999.

REGIONAL INITIATIVES

During the 1980s the United States turned an eye toward bilateral and
regional liberalization initiatives, not with the purpose of
supplanting the multilateral talks, but rather to supplement and spur
progress on that front. Regional agreements can be beneficial, but
they raise some valid concerns: although such agreements can generate
new trade by lowering barriers between participating countries, they
may also inefficiently divert trade from nonparticipants that would
otherwise supply goods and services more cheaply. From the
participants' perspective, whether the benefits of trade creation
outweigh the costs of trade diversion depends on how the agreement is
structured. There are reasons to believe trade creation will
predominate when the agreement encompasses countries that geography
has made natural trading partners: when costs of transportation are
included, countries in close proximity are more likely to be each
other's low-cost suppliers, minimizing the scope for trade diversion.
But for countries on the outside, regional agreements are more likely
to impose costs than provide direct benefits.

Sometimes regional agreements can exert a positive influence on the
multilateral process (Box 7-2) or support the participants' foreign
policy positions. For example, the benefits for the United States of
the free trade agreement with Israel, negotiated in 1985, were more
symbolic than economic. The agreement reinforced political ties
between the two countries, and Israel did reap important economic
benefits from it as well. Similarly, although economic motivations
were significant in the formation of what is now the European Union, a
contributing factor was the desire to engender a sense of community
that might prevent another intra-European war. The promotion of
democracy and political stability as well as economic stability and
development is also a factor in the Free Trade Area of the Americas
initiative, discussed below.

In the last 10 years the United States has initiated and signed a
number of important regional initiatives. The agenda for the remainder
of this century and beyond includes laying the foundation for open
trade in the Americas as well as moving toward expanded trade
throughout the Pacific Rim.

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Box 7-2._Regional Trade Agreements: Building Blocks or Stumbling
Blocks for the Multilateral Process?

Does regionalism accelerate or slow the momentum of multilateral
liberalization? Some compelling arguments suggest that the formation
of regional blocs can serve as a building block_or act as a stumbling
block_to the multilateral process.

Perhaps the most compelling theoretical argument for protectionism_and
the primary mechanism by which regionalism might act as a stumbling
block_is the optimal tariff argument. Imposing tariffs may enable a
country to exploit some monopsony power in its import markets, and so
achieve more favorable terms of trade with the rest of the world.

Moreover, a group of countries setting this optimal tariff in concert
may have more success, because of their combined market power, than if
each acted alone.  Fortunately, Article XXIV of GATT, which governs
regional trading arrangements among members, prohibits increases in
tariffs against nonparticipants. (GATS now extends the same principle
to services.) A regional trading arrangement may also undermine the
multilateral process if special interests can manipulate the
arrangement's more technical aspects (such as exemptions, phaseouts,
and rules of origin) to their advantage, or if regional initiatives
divert political capital and energy from multilateral initiatives.

On the other hand, regional arrangements can serve as building blocks
for multilateralism in several ways. They can lock in countries'
unilateral reforms, simplify negotiations by reducing the number of
countries involved, and set in motion a process of competitive
liberalization in which reluctant countries are prodded into
liberalizing by the threat of exclusion from a regional agreement.

The history of NAFTA provides an example of how regionalism can lock
in reforms. By entering into NAFTA, the then-President of Mexico hoped
to prevent his successors from undoing the unilateral liberalizations
his government had undertaken since the mid-1980s. Mexico's reaction
to the peso crisis of 1994-95 showed that this lock-in strategy
worked. Unlike in the 1982 debt crisis, when Mexico raised trade
barriers against all its trading partners, in the 1994-95 crisis
Mexico continued to reduce tariffs for its NAFTA partners (while
raising tariffs against some other countries).

Negotiating with 150 other countries over dozens of sectors, as WTO
negotiators must do, can be inefficient and difficult. The process can
be made more efficient if countries can join into customs unions and
thus negotiate as a larger unit. Also, within
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Box 7-2._continued

such a group it may be easier to test out innovative agreements in
certain areas_such as services, investment, dispute settlement, and
competition policy_before introducing their provisions into the
multilateral negotiations.

The events of 1993 demonstrate the power of competitive
liberalization. The Administration is said to have made a ``triple
play'' that year, with the passage of NAFTA, the pathbreaking APEC
summit, and the conclusion of the Uruguay Round. These not only were
landmark achievements in themselves but interacted with each other in
advantageous ways. By pushing NAFTA through the Congress despite
strong opposition, the President revealed the political will to make
free trade commitments stick. Combined with the upgrading of APEC
negotiations to a high-profile leaders' meeting in Seattle, the
passage of NAFTA sent a strong signal to the Europeans that the United
States had serious regional alternatives should the Uruguay Round of
GATT negotiations fall apart. German policymakers have reportedly
stated that this was part of their motivation for prevailing on their
EU partners to make certain concessions that allowed the GATT
negotiations to be successfully concluded in December 1993.

These examples show that there are both positive and negative links
between regionalism and the multilateral negotiations. Every regional
bloc will have its share of each. In the end, however, the evidence
suggests that the recent growth of regionalism has served more to
foster than hinder progress toward liberalization. Those groups of
countries that have participated in regional liberalization have often
tended to reduce their barriers against nonmembers at the same time
that they do so internally.
-------------------------------------------------------------------------

The Free Trade Area of the Americas

The idea of a free trade area encompassing all of the Americas took
its first step toward realization in December 1994, when the President
of the United States and leaders of 33 other Western Hemisphere
countries met in Miami for the first hemispheric summit since 1967.
There they committed their governments to concluding the negotiation
of a comprehensive free trade agreement no later than 2005, with
concrete progress due by the end of the century. The Miami Summit led
to three meetings of the countries' trade ministers, at which 12
working groups were established to lay the foundation and begin
preparations for actual negotiations toward a Free Trade Area of the
Americas (FTAA).

The United States has championed this regional initiative and remains
actively engaged in it, as a means of fostering closer political and
economic ties with and further trade liberalization in our hemispheric
neighbors. Building on unilateral liberalizations undertaken in the
late 1980s, many Latin American countries have already negotiated
preferential trading arrangements with each other. Examples include
MERCOSUR (which includes Argentina, Brazil, Paraguay, and Uruguay),
the revitalized Central American Common Market, and the Andean
Community. Their dismantling of trade barriers, both unilaterally and
in the context of regional agreements, reflects a significant shift
away from traditionally inward-oriented trade policies toward more
liberalized regimes. Although generally reflective of progressive
policy programs, the preferential nature of these arrangements is of
concern to the United States, because it means that other countries
are gaining favored access to some of our most natural trading
partners. As these arrangements proliferate, the potential benefits to
the United States of participating in them_and the costs of remaining
outside_are rising. Chile, for example, is now linked in preferential
trading agreements with every major country in the hemisphere except
the United States. For this reason, U.S. exports to Chile remain
subject to tariffs averaging 11 percent, while exports from other
Western Hemisphere countries increasingly enjoy duty-free access.
Although Chile is only one country, it is a salient example of a
growing trend.

An FTAA will bring substantial benefits to all countries in the
region, which had a combined GDP of over $9 trillion and a market of
756 million people in 1995. These benefits include not only a
significant reduction of import barriers but also deeper geopolitical
ties. The general lowering of trade barriers will be particularly
beneficial to the United States, since our market already is much more
open than most. Although this benefit could in principle be achieved
through the multilateral process, regional action probably offers more
immediate and complete liberalization.

Asia-Pacific Economic Cooperation

Created in 1989, the APEC forum began to take on deeper significance
in November 1993, when the President hosted the first-ever summit of
the leaders of the member countries, in Seattle. This meeting elevated
the importance of the organization and set the stage for a second
summit, in Bogor, Indonesia, in 1994. There the leaders announced the
goal of achieving ``free and open trade and investment in the region''
by 2010 for the developed-country members and by 2020 for the
developing countries in the group (Box 7-3). In Osaka, Japan, the
following year, an agenda was laid out for achieving that goal, and in
1996, in discussions at Subic Bay in the Philippines, implementation
of the agenda got under way. The most immediate result of the Subic
Bay meeting was a call by the APEC leaders for the elimination of all
tariff barriers among member countries to trade in the information
technology sector. This declaration laid the foundation for the
Information Technology Agreement described above.

-------------------------------------------------------------------------

Box 7-3._APEC Tariff Reductions and Other Initiatives

Although APEC members have not yet engaged in formal negotiations over
tariff reductions, many have already implemented dramatic reductions
in their tariff levels. Between 1988 and 1996 the average applied
tariff among APEC members fell by more than a third, from 15.4
percent to 9.1 percent (Table 7-1).

The progressive lowering of tariff barriers is only one aspect of the
APEC Action Agenda. This agenda details steps that APEC members have
agreed to take to promote greater economic interaction throughout the
region. Other agenda items include reducing barriers to competition in
the fast-growing air transport market, and a variety of measures
designed to reduce the cost of doing business in the region. These
include the development of an infrastructure opportunity data base,
the promotion of uniform customs classifications and procedures, and
advances in the harmonization of standards.


~
TABLE 7-1.--Tariff Rates of Asia-Pacific Economic Cooperation Members
[Percent, simple average]
------------------------------------------------------------------------------
Economy                         1988                 1996
------------------------------------------------------------------------------ Australia . . . . . . . . . . . . . . . . .   15.6                  6.1
Brunei  . . . . . . . . . . . . . . . . . .    3.9                  2.0
Canada  . . . . . . . . . . . . . . . . . .    9.1                  6.7

Chile . . . . . . . . . . . . . . . . . . .   19.9                 10.9
China . . . . . . . . . . . . . . . . . . .~   40.3                 23.0
Chinese Taipei (Taiwan) . . . . . . . . . .   12.6                  8.6
Hong Kong . . . . . . . . . . . . . . . . .     .0                   .0

Indonesia  . . . . . . . . . . . . . . . .    20.3                 13.1
Japan . . . . . . . . . . . . . . . . . .      7.2                  9.0
Malaysia . . . . . . . . . . . . . . . . .    13.0                  9.0

Mexico . . . . . . . . . . . . . . . . . .    ~10.6                 12.5
New Zealand. . . . . . . . . . . . . . . .   ~ 15.0                  7.0
Papua New Guinea . . . . . . . . . . . . .     (1)                  (1)

Philippines  . . . . . . . . . . . . . . .    27.9                 15.6
Singapore . . . . . . . . . . . . . . . . .     .4                   .0
South Korea . . . . . . . . . . . . . . . .   19.2                  7.9

Thailand . . . . . . . . . . . . . . . . .    40.8                 17.0
United States . . . . . . . . . . . . . . .    6.6                  6.4

Average. . . . . . . . . . . . . . . . . .   15.4                  9.1
------------------------------------------------------------------------------
/1/ Not available.
Sources: Institute for International Economics.


Fundamental to relations within APEC is the pledge of ``open
regionalism.'' APEC seeks to serve as a building block to the
multilateral system of liberalization and not a stumbling block. As a
start toward implementing this vision, in November 1996 APEC served as
a catalyst for the ITA. APEC members are engaged in a process that
builds upon the success achieved in the ITA. At the most recent
summit, in November 1997 in Vancouver, Canada, the APEC leaders agreed
to expand APEC's role as a catalyst for global market opening, by
endorsing liberalization initiatives in 15 sectors. Among these are
environmental services and technology, medical equipment and
instruments, and chemicals_sectors in which the United States is a
major exporter. APEC will thus capitalize upon the fact that its
collective size and importance in world trade will help in leveraging
multilateral agreements that will cut trade barriers globally. The
leaders' decision recognizes the importance of taking APEC sectoral
initiatives into the WTO where appropriate, and including binding
global agreements, as was done with the ITA.

With its member countries now accounting for approximately half of
world output and trade, the APEC region has grown in significance for
the United States. Already the share of U.S. exports going to APEC
members has increased from 52 percent in 1986 to 70 percent in 1996.
APEC is also demonstrating its importance in other ways: in November
1997 APEC leaders embraced a strategy for dealing with the ongoing
currency crisis in East Asia.

BILATERAL INITIATIVES

As successful as these multilateral and regional initiatives have
been, significant barriers to U.S. exports remain, in some countries
more than others. The reduction of formal barriers to trade worldwide
often exposes cross-country differences in institutions and norms that
also serve to limit trade. To the extent these practices are
country-specific, it is sometimes easier to address them on a
bilateral rather than a multilateral or regional basis. This
Administration has a record of actively pursuing remedies to trade
barriers abroad. These efforts are designed not only to liberalize
markets for American products, but to provide broad market access for
all would-be exporters.

China

China is the world's 10th-largest trading nation and the United
States' fourth-largest trading partner. U.S. exports to China have
nearly quadrupled in the last decade. However, China's wide array of
barriers to trade, together with the relocation of the source of many
of our imports to China, has resulted in a U.S. trade deficit with
China of over $39.5 billion in 1996, an increase of more than $5.7
billion from 1995. Trade data from 1996 show that, when both goods and
services are included, our recorded deficit with China exceeds our
deficit with Japan. U.S. exports to China grew a slight 8 percent in
1997 (through November), compared with 21-percent growth in U.S.
imports from China. Further opening the Chinese market to our exports
is an important goal of U.S. bilateral and multilateral negotiations
with China.

Negotiating the terms of China's accession to the WTO is a major part
of the Administration's effort to address this trade imbalance. The
focus of the WTO access negotiations rests on opening China's market
to foreign goods and services and bringing China's trade regime into
conformity with international trade rules. The United States is also
pursuing an active bilateral agenda with China to resolve outstanding
issues ranging from market access for U.S. agricultural exports
(including citrus, wheat, and meat) to protection for intellectual
property rights.

European Union

The trading relationship between the United States and the European
Union is important and strong, but it has had its frictions. The
U.S.-EU Agreement on Mutual Recognition of Product Testing or Approval
Requirements, concluded in June 1997, is evidence of this strength.
When fully implemented, the agreement will require each government to
recognize the results of product testing and certification
requirements set by the other, thus eliminating the need for
duplicative testing, inspection, and certification requirements for
products in trans-Atlantic trade. The agreement reduces trade
barriers in six areas_telecommunications, medical devices,
electromagnetic compatibility, electrical safety, recreational craft,
and pharmaceuticals_covering approximately $50 billion in two-way
trade. The agreement will allow products and processes to be assessed
in the United States for conformity to European standards, and vice
versa, saving U.S. exporters more than a billion dollars annually.

In recent years, however, longstanding divides between the United
States and the European countries have reemerged, along with new areas
of disagreement. In 1997 alone the United States has had to deal with
disputes resulting from decisions made and deadlines set by the
European Commission. The first involved a European ban on products
made with so-called specified risk materials; these are foodstuffs
that the European Union considers potentially contaminated with the
agent that causes bovine spongiform encephalopathy, or mad cow
disease. The other disputes involved restrictions on the imports of
furs obtained through the use of leghold traps, the biogenetic
alteration of corn, and the process by which wine for export to Europe
is made. The fur dispute was resolved by an agreement to phase out the
use of certain traps in the United States; the other issues remain
outstanding.

Japan

Japan is our second-largest trading partner. Our two countries share a
long history of negotiated access to the Japanese market for U.S.
goods. A series of agreements have sought to address a range of
structural features of the Japanese economy that act as market access
barriers; these include closed distribution systems, overregulation,
lack of transparency in procurement practices, and exclusionary
business practices. In addition, the two countries have negotiated
sectoral agreements on semiconductors, wood products, cellular phones,
construction, and other goods and services.

Since the beginning of this Administration the United States and Japan
have negotiated 33 trade agreements. Under the U.S.-Japan Framework
for a New Economic Partnership Agreement, reached in 1993, the two
countries have negotiated sectoral agreements covering such sectors as
automobiles and auto parts, insurance, financial services,
telecommunications, medical technology, and flat glass. These are
generally sectors in which the United States is competitive but in
which our share of the Japanese market often lags behind our shares in
the same sectors in other industrial countries' markets. These
agreements included objective criteria to guide the two countries in
evaluating their success. Under the Framework Agreement, bilateral
agreements on structural issues including deregulation, investment,
and intellectual property rights also were reached.

Although noteworthy progress has been made under many of these
agreements, progress has fallen short in some areas. The United States
places priority on full implementation of its bilateral agreements
with Japan and believes that more vigorous enforcement is necessary to
ensure that their goals are achieved. In addition, the United States
continues to seek new market access agreements with Japan to address
barriers in specific sectors. Market opening is consistent with a
larger deregulation program currently under way within Japan. Under
the Enhanced Initiative on Deregulation and Competition Policy, to
which the President and the Japanese Prime Minister agreed in June,
four sectors_financial services, telecommunications, housing, and
medical devices and pharmaceuticals_were identified as the focus of
efforts in this area.

The United States also sees the WTO dispute settlement process as
useful in addressing specific Japanese market access barriers. In
December 1997 the United States reached a settlement with Japan
regarding Japan's compliance with a WTO decision against its
discriminatory taxation of distilled spirits. The United States is
also pursuing a case against Japan's varietal testing requirements for
fruit. On another front, the United States challenged an array of
measures that Japan has put in place over the past 30 years to
restrict imports of photographic film and paper, but the WTO panel did
not rule favorably.

Negotiations in both regional and multilateral fora have also
generated real market opening in Japan. The WTO agreements on
information technology, basic telecommunications, and financial
services will increase U.S. market access to many WTO members,
including Japan.

THE EFFECTS OF MARKET OPENING

This Administration's efforts to open markets worldwide, reviewed in
the previous section, are part of a long U.S. tradition of leadership
in market liberalization. These efforts have been remarkably
successful: barriers to international transactions, on average, are at
a mere fraction of their 1930s levels. But it is not enough to measure
the extent to which markets have been opened. The bottom line for the
United States is the net benefits this opening brings, not just for
the U.S. economy as a whole but for typical American workers and
consumers. This section discusses the sources of benefit from
international trade and some estimates of the impact of trade on U.S.
GDP. This is followed by a discussion of international trade's impact
on U.S. workers.

THE BENEFITS OF TRADE LIBERALIZATION

The benefits to an economy from international trade are of two types:
static gains provide a one-time increase in income, whereas dynamic
gains result in a more or less permanent increase in the economy's
rate of growth. The former can be significant, but it is the
accumulation over time of the latter that can generate much larger
improvements in living standards.

The primary source of the static gains from trade is specialization,
which allows resources to be used more efficiently. When one country
produces and exports those goods that it can produce relatively
cheaply (for instance, wheat in the United States) and imports those
that are relatively cheap to produce abroad (for example, coffee from
Brazil), this trade can boost living standards on both sides of the
transaction. Such trade can be beneficial even in cases where one
country could produce both goods more efficiently. This notion,
commonly referred to as comparative advantage, is straightforward when
applied to individuals_each of us sometimes purchases from others some
goods or services that we could make or perform even better ourselves,
because we realize that our time is most profitably spent doing those
things we do best. But the principle applies equally well to
countries. When each country specializes in what it produces
relatively more efficiently, the resources of both are put to use
where they generate the greatest economic value. Free trade thus is a
positive-sum, not a negative- or a zero-sum, game.

The benefits of more efficient resource allocation are augmented when
economies of scale are present. For some goods, such as automobiles,
the average cost of production falls as more of the good is produced.
Again, opening markets to trade allows production of such goods to be
concentrated in those countries that produce them relatively well.
They can then produce more of those goods, exploiting these economies
of scale. This helps explain why the United States trades more with
similar countries (Canada and Europe, for example) than dissimilar
ones: such countries presumably have similar resource endowments, and
this limits the potential gains from more efficient allocation, but
they can still gain from exploiting scale economies. Such trade often
offers yet another benefit: besides making goods cheaper, it increases
the variety of goods available to both consumers and producers.

By encouraging continuous productivity improvements, international
trade can increase an economy's growth rate; this is the source of the
dynamic gains from trade. Trade stimulates productivity improvements
most directly through its procompetitive effects. By subjecting
domestic firms to foreign competition, trade gives them an incentive
not only to lower prices, but also to strive to enhance productivity,
which further reduces prices by lowering average cost. These gains
from increased competition differ from the other gains from trade in
that they are recurring: although competition is only introduced once,
it leads to a cycle of productivity improvements and quality
enhancements that continue to benefit the economy indefinitely. Trade
(and international investment, discussed below) can also lead to
increases in the growth rate by facilitating the transfer of
technology between countries. Although the protection of intellectual
property rights in the short term is important for maintaining the
incentive to conduct research and development, over the longer term
the free flow of technological advances across borders will encourage
ever more efficient utilization of the world's scarce resources.

MEASURING THE GAINS FROM TRADE

How are the benefits from liberal trade policies to be gauged in
practice? The difficulty in measuring the effects of international
trade agreements is that they are but one event among many. In an
economy the size of the United States, GDP both rises and falls in
response to many factors, most of which have nothing to do with trade
agreements.

NAFTA provides a prime example of the problems involved. NAFTA entered
into force in January 1994. The following December, Mexico experienced
a deep economic and financial crisis for reasons unrelated to the
agreement. The result, in 1995, was a steep fall in output in Mexico,
an increase in unemployment, and a drop in real wages there. A natural
side effect of the crisis was a dramatic decline in Mexico's imports,
brought on by greatly reduced domestic income and demand, higher
import prices due to devaluation of the peso, and, to a limited
extent, higher tariff barriers against non-NAFTA trading partners.
Despite this crisis-induced decline in trade with Mexico, it is
possible to discuss gains for the U.S. economy derived from NAFTA.
Because of the agreement, Mexico did not raise tariff barriers against
the United States or Canada, but only against other countries. As a
consequence, not only did U.S. exports to Mexico not decline by as
much as they might have, but some believe the agreement sped the
general recovery of the Mexican economy and of imports from the United
States. Seeking to take the extraneous effects of the crisis into
account, the Administration commissioned a report, which estimated
that NAFTA increased U.S. income by $13 billion in 1996.

Despite the difficulty of disentangling the many causes of national
income growth, a large number of studies have assessed the benefits of
trade liberalizations, real and hypothetical. Some have examined the
potential benefits from removing existing restrictive measures. A
recent study of the costs of protection in the United States, for
example, suggests potential consumer gains of approximately $70
billion in 1990 (1.3 percent of GDP) from removing existing barriers.
A drawback of these studies is their inability to incorporate all the
benefits of international trade enumerated above. Although they do
capture the static costs of inefficient resource allocation, these
studies are incapable of quantifying the value of forgone varieties,
quality improvements, or productivity enhancements that would take
place in the absence of trade barriers. Thus, studies of this type
understate the benefits from trade.

Another approach to understanding the benefits of trade is to examine
the statistical correspondence between openness and growth rates
across a large sample of countries. Such cross-country studies hold
constant other well-known determinants of growth, such as investment
and education. The common empirical finding is that increased trade is
associated with higher income. For example, one recent study, using
data from 123 countries, estimated that every percentage-point
increase in openness (measured as the sum of imports and exports,
expressed as a percentage of GDP) was associated with a 0.34-percent
increase in real income per capita between 1960 and 1985. Since 1960,
U.S. openness by this measure has increased by 12.7 percent of GDP;
this estimate would imply that the increase in trade was responsible
for approximately a 4.3-percent increase in U.S. income per capita by
1997.

TRADE AND THE AMERICAN WORKER

The public debate over trade liberalization tends not to focus on
whether trade brings benefits for the economy as a whole. It is widely
conceded that it does. Instead, recent concerns have focused on the
distributional impact of increased trade. This issue arises from the
tendency of increased trade to favor some domestic industries while
putting others at a disadvantage. As export-oriented industries
expand, they draw resources away from the rest of the economy,
resulting in a relative decline in other industries. This reallocation
of resources will in all likelihood benefit some groups and injure
others. Of particular concern are the impacts on workers, including
average wages, the wages received by low-skilled relative to more
highly skilled workers, the availability of jobs in the economy, and
the extent to which workers suffer from job dislocation due to trade.
This section discusses first the effects of trade on wages, and then
the effects on employment. In each case we begin by discussing effects
in the aggregate (on average wages and total employment) and then turn
to distributional and individual effects that can be masked by the
aggregates.

TRADE AND AVERAGE WAGES

Throughout the first half of the postwar era, real average hourly
wages for U.S. production and nonsupervisory workers increased at an
average rate of about 2 percent per year. Between 1974 and 1996,
however, this measure of real wages fell by roughly 10 percent,
retreating to 1965 levels. The early 1970s also saw a dramatic
acceleration in the growth of world trade, to rates that (since 1972)
have consistently outpaced that of world income growth. This trend was
especially striking in the United States, where growth in trade
exceeded growth in output by approximately 3.5 percentage points per
year following 1972. The coincidence of increasing trade and falling
real average hourly earnings suggested to many that international
forces were the source of this decline.

This inference is probably wrong, however. To begin with, it is more
appropriate to focus on the level of total compensation (wages of all
workers plus nonwage compensation) than on wages of production and
nonsupervisory workers alone. Wages of production workers have
recently grown less rapidly than overall wages. Nonwage compensation,
which includes health care benefits, pension costs, and other fringe
benefits, has grown relative to wages in recent decades_so much so
that total real compensation has increased by almost 8 percent since
1974, despite the decline in real wages. Although this represents
slower growth of total compensation than in the 15 years before 1974,
this slowdown is more appropriately explained by factors other than
international trade, in particular by a slowdown in productivity
growth.

The compensation of labor is generally believed to be determined by
worker productivity. Between 1959 and 1973, nonfarm business
productivity (output per worker hour in the nonfarm business sector)
grew at a rate of 2.9 percent per year. Productivity growth slowed,
however, between 1973 and 1990 to approximately 1.0 percent per year.
Given the productivity slowdown, one would expect a slower rate of
increase in real compensation during this period. Adjusting
compensation by the consumer price index will not necessarily reveal
this relationship: to producers_the ones making the hiring
decisions_the real output of their workers must be judged only in
terms of the prices received for their goods, not the prices of all
goods and services that consumers buy. This implies that a more
appropriate deflator is the nonfarm business implicit price deflator.
And indeed when this measure of prices is used, a remarkable
correlation is observed between productivity growth and growth in
compensation over both periods (Chart 7-6). Policies aimed at
increasing productivity growth, rather than at reducing
international competition, are therefore more likely to increase the
growth rate of real compensation.



Although total compensation is thus driven by overall productivity
growth, there is an additional effect related to the industry in which
workers are employed. Standard theories of wage determination assume
perfectly competitive labor markets, in which workers of similar skill
should earn comparable compensation even when employed in different
industries. These assumptions, however, are not borne out in reality.
There has long been a relationship between industry and compensation,
such that individuals with similar characteristics tend to earn more
in some industries and less in others (Box 7-4). This raises the
possibility that some workers could increase their pay simply by
moving to another industry.

A recent study indicates that jobs associated with goods exports tend
to pay wages approximately 12.5 to 18 percent higher than other jobs.
As exporters typically employ relatively skilled workers, a part of
this figure is due to differences in observable skills. But even
after this factor is accounted for, a significant wage differential
remains: the adjusted wages of unskilled workers are approximately 7
percent higher, and those of skilled workers approximately 5 percent
higher, in export-oriented industries than in the rest of the economy;
accounting for differences in nonmonetary compensation results in
differentials that are larger still. Working in export industries thus
has the potential to benefit workers_and to benefit unskilled workers
even more than skilled workers.

TRADE AND RELATIVE WAGES

Some commentators have pointed to growing differences in the relative
wages of skilled and unskilled workers as an indictment of free trade.
During the 1980s, a time when U.S. trade volumes were rising, the
wages of skilled workers rose between 8 and 15 percent relative to
those of unskilled workers (depending on how one defines ``skilled'').
Given the rough coincidence of these changes, it is tempting to single
out international trade as responsible for this increasing wage
disparity. Moreover, a significant source of the expansion in world
trade has been the entry into the world marketplace of many Asian
economies well endowed with unskilled workers. Thus, casual
observation seems to support the claim that free trade is detrimental
to unskilled U.S. workers: these workers now compete with a vast pool
of unskilled workers abroad, and the expected result of this
competition is a decline in their wages.

Most careful analysis of the direct evidence does not strongly support
the notion that international trade is the major source of increasing
wage inequality. Skill-biased technological change, for instance the
use of computers and robotics, has been a more important source. The
nature of this technological change has reduced demand for unskilled
workers and increased demand for skilled workers. This phenomenon can
be expected to reduce the wages of unskilled workers relative to those
of skilled workers, and perhaps reduce them absolutely. Although the
contribution of international trade to observed productivity changes
has yet to be established, recent research indicates that
international trade is responsible for only perhaps 10 to 15 percent
of the observed increase in wage inequality during the 1980s.

Furthermore, U.S. trading patterns are inconsistent with the notion
that trade liberalization is substantially depressing the wages of
unskilled workers. Although the surge of imports from some low-wage

-------------------------------------------------------------------------

Box 7-4._Industry-Related Differences in Wages

Basic economic theory tells us that equally productive workers ought
to receive equivalent compensation. But there has long been a fairly
stable pattern of differences in wages for similar workers across U.S.
industries, as Table 7-2 illustrates. The table shows that a worker in
the petroleum industry, for example, can expect to receive about 53
percent more in compen-sation than the average U.S. worker with
similar characteristics (such as education, race, and geographic
location). Similarly, workers employed in private household services
can expect compensation that is 51 percent below the national average
for similar workers.

There is no single reason for these differences in compensation
levels. However, a number of possible explanations do present
themselves:

 Compensating wage differentials. The work environment tends to
differ from industry to industry. Work may be more pleasant or safe in
some industries, less so in others. Workers in unhealthy or dangerous
environments, for instance, may receive compensation that exceeds that
in otherwise similar jobs.

 Unobserved productivity differences. Our ability to assess the
productive characteristics of workers from survey data is limited.
Workers may have skills not reflected in measures of education. In
addition, firms may provide their workers with training that makes
them more productive on the job, and their level of compensation may
reflect this on-the-job training.

 Efficiency wages. Providing increased compensation may raise
worker productivity, for example by increasing motivation and effort,
and may reduce the probability that workers will quit. To the extent
that the benefit to employers of paying higher wages differ across
industries, compensation levels will differ.

 Monopoly rents. Competition is weaker, and therefore
profitability higher, in some industries than in others. Workers may
be able to extract some fraction of these higher profits in the form
of higher compensation. Differences in the profitability of firms and
the bargaining power of workers can thus give rise to differences in
compensation across industries.

In the case of compensating wage differentials or exogenous skill
differences, moving a worker from one job to another will not make
that worker better off. In the first case the workeris merely being
compensated for bearing an additional burden,
-------------------------------------------------------------------------

-------------------------------------------------------------------------

Box 7-4._continued

and in the second for some unobservable productive capacity, in the
same way that we expect workers to be compensated for higher levels of
education. But in cases where positive wage differentials are due to
skills acquired on the job, efficiency wages, or monopoly rents,
increasing the number of export jobs has the potential of raising the
standard of living for workers.
-------------------------------------------------------------------------



TABLE 7-2.--Industry Compensation Premiums, 1984
[Percent]
------------------------------------------------------------------------------
Top 10 industries                         Bottom 10 industries
Industryï¿½1A1           Premium                  Industryï¿½1A1           Premium
------------------------------------------------------------------------------
Petroleum . . . . . . . .   53.3            Leather . . . . . . . . . .  -11.8
Tobacco . . . . . . . . .   42.6            Repair services . . . . . .  -12.3
Communications. . . . . .   37.1            Entertainment . . . . . . .  ~-14.9
Public utilities. . . . .   34.2            Apparel . . . . . . . . . .  -15.0
Transportation equipment.   28.2            Other retail trade. . . . .  -17.3
Mining. . . . . . . . . .   27.7            Education services. . . . .  -19.4
Primary metals. . . . . .   26.2            Personal services . . . . .  -22.3
Chemical. . . . . . . . .   23.1            Eating and drinking . . . .  -28.3
Paper . . . . . . . . . .   19.9            Welfare services. . . . . .  -32.8
Machinery, except                            Private household
electrical . . . . . . .   18.2             services . . . . . . . . .  -50.8
------------------------------------------------------------------------------
1ï¿½1ATwo-digit Census Industrial Classification industries.

Note.--The premium is calculated as the percentage by which compensation in
the industry (wages plus benefits) exceeds the national average for all
industries, after accounting for worker characteristics.

Source: Ka~tz, Lawrence F., and Lawrence H. Summers, ``Industry Rents:
Evidence and Implications,'' Brookings Papers: Microeconomics 1989.


countries has received tremendous attention, the United States still
buys the bulk of its imports from other advanced industrial countries,
whose workers have similar skills and wages. If we define low-wage
countries as those whose average wage is half or less that in the
United States, trade with such countries in 1990 was roughly the same
as it was in 1960, when Japan and much of Europe qualified as low-wage
countries. Imports from low-wage countries were 2.2 percent of GDP in
1960 and rose to only 2.8 percent of GDP by 1990. In addition, the
trade-weighted average hourly manufacturing wage of U.S. trade
partners was 88 percent of that in the United States in 1990; this
seems much too small a difference to have produced the observed
changes in relative wages.

This raises a more subtle but no less valid point: in order for
international trade to result in a decrease in the wages of
low-skilled workers, the price of low-skill-intensive imports must
necessarily fall. But prices of such imports actually rose during the
1980s and 1990s.

In short, while trade may contribute a bit to the widening wage gap
between skilled and unskilled workers, the evidence does not suggest
that it is the prime source of the gap, nor that it hurts unskilled
workers in an absolute sense.

TRADE AND AGGREGATE EMPLOYMENT

Much of the debate over trade has been over jobs. Critics of more open
trade have claimed that trade destroys jobs; advocates often argue
that trade creates them. According to basic economic theory, however,
in general trade does neither. Today the United States is close to
full employment. In such times, market opening means that
opportunities will decrease in some industries and increase in
others. The effect of export growth in this circumstance is not to
increase the number of jobs but rather to increase the number of
``good'' jobs.

There are circumstances, however, in which trade can lead to job
gains: when unemployment rates are high, the expansion in exporting
industries can be accomplished by hiring unemployed workers. In
January 1993 U.S. unemployment was still 7.1 percent (even though the
recession had ended 2 years earlier). During the next 2 years the
number of American jobs supported by exports rose by 446,000, helping
reduce unemployment to its present level below 5 percent. As the
economy comes closer to full employment, however, trade's positive
effect on aggregate U.S. real incomes shows up less in the form of
higher employment and more in the form of higher real compensation for
workers.

TRADE AND JOB DISPLACEMENT

As reported in the 1997 Economic Report of the President, public
opinion polls continue to reveal a low sense of job security among
American workers. This is surprising in that, historically, periods of
robust economic activity such as the present one have been
characterized by much less anxiety over job loss. This anxiety is
also evidenced by a relatively low propensity for workers to quit
their jobs_a low quit rate suggests uncertainty about the prospects
of finding a new job. Rightly or wrongly, workers may associate much
of their concern about job security with the expansion of trade.
These concerns must be addressed. This means going beyond aggregate
measures of expanding employment that might mask individual hardship.

The evidence suggests that, for a variety of reasons, trade is not a
primary contributor to total job displacements. Because the U.S.
economy is highly dynamic, a great deal of job turnover occurs as new
firms go into business or expand and others drop out or contract. Data
from the 1980s reveal that trade contributed at most 10 percent of the
observed displacements from manufacturing in the worst year of that
decade; in most years it contributed significantly less. Most of the
job loss resulted from other forces, principally technological change.

Trade can lead to increased displacements because an increase in
imports is likely to displace workers in import-competing domestic
industries. However, expanded export opportunities may reduce the
incidence of displacements in other sectors. Some evidence suggests
that expanded export opportunities have been sufficient to offset the
effect of growing imports on total displacements. When the effects of
increased imports and exports over the 1980s are combined, there is
evidence that changing trade patterns over this period left the total
volume of displacements relatively unchanged. This is possible
because, over time, the displacements resulting from imports were
generally offset by expansion in export-oriented industries, which
served to reduce the number of displacements. The net effect was then
only a reshuffling of displacements across industries and across time.

Although trade may not have increased the number of displaced workers
in the 1980s, in some cases it may have increased the hardship
associated with displacement. By shifting production from one industry
to another, international trade brings about a shift in employment
from one industry to another. This change in the distribution of
employment, although it generally increases the quality of jobs
available, can lead to greater transitional hardship than some other
causes of displacement, for instance the closure of an inefficient
plant in an otherwise thriving industry, because it is more likely to
involve finding a job in a new industry.

In recognition of the relationship between imports and labor
displacements, U.S. trade laws have included provisions for trade
adjustment assistance since 1962. This assistance offers cash
benefits, in the form of extended unemployment insurance benefits, and
retraining to workers who lose their jobs as a result of trade. It
also pays for job search assistance and relocation expenses. Since the
inception of these programs, about 2 million workers have been
certified as eligible. A smaller number have actually received
benefits, as many found jobs in the meantime.

The Administration is conscious of the need to provide support for
workers injured by international trade, but also aware that not all
workers deserving of such support are now getting it. Accordingly, the
President has made significant reform of the existing trade adjustment
assistance programs a priority. One such reform is to extend
adjustment assistance to all workers displaced from firms that have
shifted production to another country. The NAFTA legislation already
provides such assistance to workers displaced from companies that have
shut down their plants and moved production to Mexico or Canada. Also
in need of assistance are displaced secondary workers_those employed
as subcontractors or in businesses that provided services to plants
that have moved abroad. The NAFTA legislation offered benefits for
these workers as well, but most have been unaware they were entitled
to the same types of benefits as other dislocated workers. These
extensions of assistance, coupled with efforts to streamline the
certification process, should significantly improve the quantity and
quality of assistance provided to workers displaced by trade and
investment liberalization.

THE U.S. TRADE BALANCE

A popular measure of the impact of trade policies is the trade
balance, or the difference between exports and imports of goods and
services. But use of the trade balance as a measure of the success of
market-opening endeavors is problematic. Changes in the trade balance
are seldom related to specific market-opening efforts; indeed, the
trade balance is generally determined by macroeconomic factors, not
microeconomic barriers to trade.

National income accounting identities demonstrate that the difference
between exports and imports must equal the difference between national
saving and domestic investment. In practice this relationship applies
to the current account balance rather than to the trade balance. Trade
in goods and services is by far the largest component of the current
account, but it also includes overseas investment income and
transfers. Measurement issues can also intrude to obscure the
accounting identity. In particular, the existence in recent years of
a large statistical discrepancy between the income- and the
product-side measures of GDP has led to a situation in which the gap
between official measures of saving and investment has narrowed as
the current account has widened (Chart 7-7). The source of the
statistical discrepancy is, by definition, unknown at present. But if,
for example, the current account and investment are being measured
relatively accurately, the current official measure of saving is too
high.

Measurement issues aside, in periods when domestic investment exceeds
national saving, the current account balance will necessarily be in
deficit, whatever the state of trade policy. Whether the Nation is
borrowing to finance a consumption binge or an investment boom, the
current account deficit that results will represent the inevitable
consequence of these aggregate borrowing decisions_not the failure of
market-opening policies.

Until the 1980s the current account of the U.S. balance of payments
was seldom far from balance. Since then, however, both the trade
balance and the current account balance have been in substantial
deficit, as growth in imports has largely exceeded growth in exports.
These deficits have not arisen because we in the United States have
expanded access to our markets while our trading partners have not
done the same. In fact, over this period our major trading partners
have



reduced their trade barriers more than has the United
States.Rather, the explanation is macroeconomic. As Chart 7-8 shows,
changes in the trade deficit have often closely followed movements in
the real exchange rate. The exchange rate, in turn, reflects global
demand for U.S. dollars by those who want to buy U.S. goods and
assets, and the supply of dollars from those who want to use them to
buy foreign goods and assets.

The trade deficit grew in the early 1980s as the Federal Government
maintained a mix of tight monetary policy and expansionary fiscal
policy. Growing Federal budget deficits were a drain on  the pool of
domestic saving, requiring new investment to be financed increasingly
through borrowing on international capital markets. In particular, the
saving shortfall and tight monetary policy raised U.S. interest rates,
which in turn caused the real exchange rate of the dollar to
strengthen. As the dollar appreciated, imports became cheaper for
Americans and U.S. exports more expensive for foreigners, so that the
U.S. trade balance went deep into deficit. The deficit was thus
financed by borrowing abroad. This problem was often referred to as
the ``twin deficits,'' emphasizing the role of the Federal budget
deficit (that is, negative Federal Government saving) in the low
overall national saving rate and the resulting trade deficit.

Since 1992 the Federal budget deficit has fallen steadily and national
saving has increased, yet the trade deficit has once again grown. This
is because of the strong boom in investment. Moreover,



the trade deficit tends to widen when the economy is growing rapidly.
As Chart 7-9 shows for the United States, import growth is strongly
correlated with growth in national income (as measured by GDP)_as our
incomes rise, we demand more goods and services generally, including
more foreign goods and services. The faster our incomes are rising
relative to foreign incomes, the more our demand for imports can be
expected to accelerate relative to that for our exports (which are
foreigners' imports). The result is a growing trade deficit here at
home. Arguably, a current account deficit is less worrisome when it is
accompanied by rising saving and investment.

At the beginning of 1997 it seemed likely that the U.S. growth rate
would fall behind that of our trading partners in Asia and elsewhere,
which would help reduce the U.S. trade deficit. Instead, U.S. growth
and import demand remained unusually strong, while much of the rest of
the world grew less rapidly than expected. However, as discussed in
Chapter 2, the dollar appreciated, keeping the nominal trade deficit
from widening. The currency crisis and slower growth that hit East
Asia in the second half of the year suggest that the U.S. deficit is
likely to grow in 1998.

The current trade deficit reflects decisions by households and
businesses, policy choices, and the strength of the U.S. economy,
particularly in the context of financial instability and slowing
growth abroad. In theory, a smaller deficit might be realized with a
different mix of fiscal and monetary policy, but it would bring
problems of its  own. In particular, under current conditions of
very low unemployment, an increase in the trade balance would simply
crowd out growth in other sectors. The additional demand for U.S.
goods and services would put upward pressure on inflation and
interest rates, and other sectors would have to contract to make
room for the rising net exports. In other words, the trade deficit
has acted as a safety valve for the current economic expansion.
Imports of goods have kept inflation low, while imports of capital
have kept interest rates low, helping to sustain rapid income growth.
In the strongly expanding full-employment economy that the United
States now enjoys, it should be easier for Americans to see that
trade deficits do not necessarily reduce output and employment.



FOREIGN DIRECT INVESTMENT

Although trade has been a primary focus of the Economic Report of the
President since its inception, capital flows have become increasingly
predominant in international transactions. A significant share of
these flows has taken the form of foreign direct investment (FDI),
wherein the investor acquires or increases foreign assets in which it
then has some lasting interest or influence. In recent years growth in
recorded FDI has outpaced even the rapid growth of trade. In the last
decade nominal FDI outflows from the United States rose an average of
17 percent per year to reach $88 billion in 1996; growth in FDI
inflows averaged 8 percent per year to $77 billion (Chart 7-10).



Commentators tend to speak in universal terms about the motivations
for FDI, but in reality no single factor determines why a firm chooses
to become a multinational enterprise and operate affiliates in foreign
countries. It may be to take advantage of unique opportunities only
available overseas (for example, to develop new oil fields), to lower
production costs by exploiting international comparative advantage, or
to gain or improve access to foreign markets by avoiding trade
barriers and transportation costs. Although a firm always has
alternatives to FDI, such as exporting or licensing foreign firms to
produce its goods, sometimes it is more cost-effective to internalize
operations within the firm's command-and-control structure rather than
conduct arm's-length transactions. This is especially true as
telecommunications technology has improved, making the coordination of
foreign operations easier.

FDI and trade are interlinked in a number of ways. Often, FDI is a
substitute for exporting: firms invest in operations abroad in
response to tariffs or other barriers that hinder the export of goods
to those markets. But FDI and trade are also complementary. In 1994
reported intrafirm trade_the cross-border transactions between
affiliated units of multinational companies_accounted for one-third of
U.S. exports and two-fifths of U.S. imports of goods. An understanding
of the large and growing role of FDI in modern trade patterns may be
useful in assessing the benefits of this important aspect of our
integrating world economy.

As the importance of international direct investment has increased,
countries have moved to negotiate a set of rules for FDI along the
lines of those for trade. Unfortunately, many misunderstandings remain
regarding FDI, which threaten to hinder these efforts (Box 7-5).
Before reporting on the progress of these efforts, this section
reviews recent trends in FDI flows and the ways in which both the home
and the host country benefit from FDI.

-------------------------------------------------------------------------

Box 7-5._Fears and Facts about Foreign Direct Investment

In the 1980s concerns arose in the United States that the rapid rise
in inward FDI would have adverse effects on American workers. Some
feared that foreign-controlled affiliates that displaced U.S. firms
might change the composition of employment, moving  ``good'' jobs to the
home country and offering only ``bad'' jobs in the United States. In
fact, foreign multinationals in the United States pay higher than
average wages, suggesting that in fact they provide good jobs. When
net FDI flows turned outward during the 1990s, the concern became that
U.S. companies would begin outsourcing much of their production to
other countries, again at the expense of jobs and wages at home. This
seeming contradiction_that inward and outward FDI would have similar
effects on U.S. workers_may reflect how little was actually known
about the effects of FDI.

Unlike trade, which has been the subject of study for hundreds of
years, FDI has been subjected to little rigorous study until recently.
As more has been learned about FDI, many of these initial fears have
subsided. The following are some fears that have been recently
expressed about FDI, and the facts that we now know.

Fear: Won't U.S. industries leave for low-wage developing countries?

Fact: During the NAFTA debate, some voiced concern that lowering
barriers to investment in Mexico would result in a large movement of
U.S. industry there, as firms exploited low Mexican wages. But since
the passage of NAFTA in 1993, Mexico's share of the U.S. outward FDI
position has decreased. The reason there has been no mass exodus of
U.S. industry to Mexico or to other low-wage countries is simple:
there is no free lunch_for multinationals as for the rest of us. Real
wages may vary significantly across countries, but studies show that
these differences are linked to productivity differences, just as
economic theory would predict. Low wages are not a sufficient reason
to move production to a foreign country, if low pro
-------------------------------------------------------------------------

-------------------------------------------------------------------------

Box 7-5._continued

ductivity there raises the labor cost per unit of output to a level
close to that of the United States. The vast majority of U.S. FDI
continues to be with other high-wage countries, so clearly other
motivations than the potential for low-wage outsourcing are behind the
greater part of FDI.

Fear: Are U.S. firms that invest abroad exporting jobs?

Fact: It may seem reasonable to suppose that a U.S. firm that hires
workers in an overseas affiliate is contributing to U.S. unemployment,
since the firm could be hiring U.S. workers to do the same job here.
Evidence shows, however, that generally this is not the case:
increases in employment in foreign affiliates of U.S. firms are often
associated with increases in employment at the parent as well. What
employment substitution there is seems to be occurring entirely
offshore, between countries competing for U.S. FDI, not between U.S.
parents and their foreign affiliates. Far from exporting jobs, it
appears that creating jobs overseas creates jobs at home as well.

Fear: Doesn't U.S. FDI abroad represent domestic investment forgone?

Fact: With the surge in outward FDI in recent years, FDI outflows now
amount to more than 10 percent of gross private nonresidential fixed
investment. However, when a U.S. firm invests abroad, that does not
necessarily mean it would have invested here instead if FDI had not
been an option. It might then have chosen not to invest at all.
Moreover, two-thirds of recorded outflows in 1996 were actually the
reinvested earnings of foreign affiliates, not capital originating in
the United States. Considering only actual capital outflows, a recent
study estimated that outward FDI averaged only 0.9 percent of
nonresidential fixed investment between 1970 and 1990_and the share
has been trending downward. Capital outflows are also largely
compensated by foreign investment inflows. Evidence suggests that a
complementarity may exist between the investment decisions of domestic
and foreign firms, which would imply that reciprocal direct investment
between the United States and other industrial countries increases
total investment in all countries that participate.

In short, opponents of FDI have incorrectly framed it as a zero-sum
venture, where for one country to gain, another must lose. Both the
theoretical arguments of the benefits of FDI and the evidence now
available suggest that FDI can provide net gains for all parties.
-------------------------------------------------------------------------

CURRENT TRENDS IN FDI

The United States remains both the largest source of and the largest
host to FDI in the world. Throughout most of the postwar period the
United States has been a net direct investor overseas, with FDI
outflows exceeding inflows (Chart 7-10). However, in 1981  the balance
of U.S. FDI flows turned inward for the first time, led by a large
expansion of investment in the United States by Japanese and U.K.
firms. This direct investment by foreign firms in the United States
grew rapidly throughout the 1980s, peaked in 1989, and then dropped
sharply in the early 1990s. Investment abroad by U.S. firms has
increased tremendously in the 1990s, so that since 1991 the balance of
FDI flows has once again been outward. These trends continue: in the
first three quarters of 1997, FDI outflows in the balance of payments
accounts rose to $94 billion, $14 billion more than inflows and
already surpassing the level for all of 1996 ($88 billion).

By 1996 the cumulative direct investment position of foreign firms in
the United States (the inward FDI stock), measured on a  historical
cost basis, had reached $630 billion, an increase of 60 percent since
1990. There are some accepted problems in measuring FDI precisely.
U.S. balance of payments accounting rules define FDI as financial
flows from a parent company to an overseas affiliate in which it has
at least 10 percent ownership. Thus, investment in foreign affiliates
not financed directly by the parent company is excluded. In addition,
historical cost positions are measured at the book value of purchases
each year and therefore do not adjust for capital gains (including
those due to inflation). Estimates that attempt to adjust for
increases in the market value of assets are almost double the 1996
historical cost measure. However, historical cost measurements do
indicate the distributional changes of FDI across countries and
sectors.

More than half of the reported FDI stock in the United States has
come from three countries: the United Kingdom holds the largest
share, followed by Japan and the Netherlands. The United Kingdom is
also the largest host to U.S. direct investment abroad, followed by
Canada. European countries are host to half of the stock of U.S.
investment abroad. In 1996 U.S. firms directly controlled overseas
assets of $797 billion, again valued at historical cost; member
countries of the OECD were home to over 73 percent of this investment.
Much of the rest was in Bermuda, the Caribbean, and some Asian newly
industrializing economies such as Hong Kong; this investment is
concentrated in sectors such as wholesale trade, finance, real estate,
and services. China, the second-largest host to worldwide FDI, still
represents only a negligible share of U.S. direct investment abroad.
However, between 1992 and 1996 the U.S. position in China increased at
an average rate of 50 percent per year. FDI in other Asian developing
countries has been increasing as well; however, the majority of growth
has come from investment in the higher income economies that are still
host to 75 percent of U.S. FDI in the region.

Among developing countries, Brazil, Mexico, and Panama are the largest
hosts to recorded U.S. FDI. Annual FDI flows to these countries
represent about 10 percent of the total, but the stock of U.S. FDI in
all of Latin America is still less than 12 percent of the total U.S.
position abroad. Nevertheless, the brightening economic prospects in
Latin America have been accompanied by a pronounced expansion of the
U.S. direct investment position in the region. The emerging markets
there are poised to become increasingly important to U.S. investors in
the future, especially if investment barriers are liberalized under
the proposed Free Trade Area of the Americas.

Although wages are lower in developing countries, these do not always
entail the cost advantages many people assume (Box 7-5). Rather, the
developing countries that receive the most FDI are usually those
regarded as potentially large future markets. This suggests that
companies investing in these countries hope to establish a market
presence, in the expectation of profitable future sales, and are not
simply outsourcing production for reexport to other markets.

Although the public image of FDI in the United States is often one of
large manufacturing multinationals, manufacturing accounts for only
one-third of both the inward and the outward FDI stock. Much FDI in
manufacturing occurs in motor vehicles, electronic and electrical
equipment, office machines and computers, and chemicals and allied
products. In 1996 these sectors accounted for over half of both the
U.S. FDI position abroad in manufacturing and almost half of the
foreign position in the United States (Table 7-3).

The industrial composition of U.S. FDI has evolved in tandem with that
of the U.S. economy. Much of U.S. outward FDI in past decades was
motivated by the opportunity to use U.S. technology to extract foreign
raw material resources such as oil, coal, and natural gas: in 1980 the
petroleum industry accounted for roughly 22 percent of the outward
U.S. FDI position. But this share has been falling steadily, and in
1996 the figure was less than 10 percent. Between 1980 and 1990 FDI
became associated with the relocation of manufacturing activities
abroad, in part because of the rapid expansion of foreign firms in the
U.S. manufacturing sector. More recently, a growing share of FDI is in
service industries_primarily finance, insurance, and real estate but
also wholesale and retail trade and banking_mirroring the evolution of
the U.S. economy from a manufacturing to a services economy. In 1996
service industries accounted for 52 percent of the U.S. position
abroad, exceeding the share of the entire manufacturing sector.
However, these figures may overstate the role of services, which
include sectors such as finance where large holdings of ``paper assets''
are the norm.


TABLE 7-3.-Inward and Outward Foreign Direct Investment, by
Industry, Selected Years
[Billions of dollars]
-----------------------------------------------------------------------------
U.S. direct investment   Foreign direct investment
abroad              in the United States
Industry       ---------------------------------------------------------

1980    1990    1996   1980    1990    1996
------------------------------------------------------------------------------
Petroleum . . . . . . . . . . . .   47.6  52.8    75.5    12.2    42.9   42.3
Manufacturing . .~ . . . . . . . .   89.3 170.2   272.6    33.0   152.8  234.3
Food and kindred products . . ..    8.3  15.6    36.2     4.9    22.5   28.1
Chemicals and allied products...   18.9  38 0    69.4    10.4    45.7   74.8
Primary and fabricated metals       6.3  10.5    13.6     3.6    13.7   18.7
Industrial machinery and
equipment. . . . . . . . . . ..   16.1  30.9    35.0     2.9    11.5   16.3
Office and computing machines..    9.3  22.2    21.7      .4     2.6    2.7
Electronic and other electric
equipment.  .  . . . . . . . ..    7.3  15.6    29.5     4.1    16.1   20.8
Motor vehicles and equipment. ..   11.8  20.4    31.6      .7     3.1   12.3
Other manufacturing . . . . . ..   20.6  39.3    57.2     6.4    40.1   63.3
Services  .......................   66.3 194.5   410.7    34.4   179.6  323.6
Wholesale and retail trade . ...   25.9  50.7    84.3    15.2    60.2   92.9
Banking . . . . .  . . . . . . .    7.3  20.7    32.5     4.6    18.4   31.9
Finance (excluding banking),
insurance, and real estate . ...  27.5 109.7   257.2    13.5    70.4  159.9
Other services. . . . . . . . ...   5.6  13.4    36.7     1.1    30.6   38.9
Other industries . . . . . . . ...  12.2  13.1    37.7     3.4    19.6   29.7

Communications and public
utilities . . . . . . . . . ...   1.3   4.4    20.4      .1     3.3   11.4
All industries  . . . . . .... 215.4 430.5   796.5    83.0   394.9  630.0
------------------------------------------------------------------------------
Note.-Detail may not add to totals because of rounding.
Source: Department of Commerce (Bureau of Economic Analysis).
~

Employment in foreign-owned U.S. affiliates rose from 2 million in
1980 to almost 5 million in 1995. This represents an average annual
increase of more than 6 percent, over three times the rate of growth
in nonfarm U.S. employment over the same period, and led to an
increase in the share of U.S. private industry employment in
foreign-controlled firms from less than 3 percent to 5 percent of
total employment. The share of private industry GDP accounted for
by foreign-owned U.S. affiliates has increased from 3 percent in
1980 to 6 percent in 1995. However, these increases largely represent
growth during the 1980s and early 1990s; in fact, by both measures
the foreign presence in U.S. industry has been constant or decreasing
in recent years.

THE BENEFITS OF FDI

The benefits of FDI to the economy as a whole seem less clear than the
benefits of trade. Yet in a world where trade results from differences
in relative factor abundance, capital mobility should act as a
substitute for trade. This corresponds with the notion that FDI occurs
in response to trade barriers and suggests that capital flows have
welfare implications similar to those of trade. Capital mobility can
also have macroeconomic benefits by relaxing the tradeoff between
investment and consumption. However, the benefits of FDI go beyond
increased capital mobility: FDI has direct impacts on both the host
and the home countries that have little in common with other types of
international investment, such as portfolio asset flows.

Benefits to the Host Country

The nature of the benefits of FDI to the host country is likely to
depend on whether the country is developed or developing, and on the
reasons why FDI is taking place. FDI in the higher income countries is
often a response to market access concerns. By establishing
operations closer to customers, a firm may be able to increase the
quality of support services and the ability to match products to local
tastes. The presence of multinationals also entails all the
traditional benefits of local investment, creating jobs and fostering
demand from local suppliers.

When FDI occurs in developing countries, the gains from fostering
demand from local industry may be even greater. ``Big push'' theories of
industrialization emphasize that the profitability to a single firm of
adopting new technological advances often depends on other firms'
decisions to do likewise. For example, an automobile assembly plant
requires dependable suppliers of parts and machinery, but these are
not likely to exist locally if no automobile plants exist. In this
scenario the gap between developed and developing countries occurs
because the former have managed to overcome this coordination problem.
By internalizing such transactions, often by using already established
global supply networks, multinationals can overcome the coordination
problem and provide the first step toward industrialization in a
developing country.

FDI may have additional advantages in developing countries,
particularly over portfolio investment. The ability to own a foreign
firm directly rather than through passive stock holdings may increase
the incentive to invest in countries that offer attractive
opportunities but little domestic entrepreneurial experience.
Furthermore, since the commitments involved in direct ownership imply
greater adjustment costs than under stock ownership when conditions
turn unfavorable, FDI can create a more stable investment atmosphere
by discouraging capital flight like that which plagued developing
economies in Southeast Asia in 1997. When investors are forced to
weather financial storms, a country's market volatility and
macroeconomic instability are reduced, and this may help the storms
pass more quickly.

Lastly, through direct control of their affiliates, multinationals
provide crucial links in the international dissemination of technology
and best practices. This promotes more efficient production and
resource use in home countries and rising incomes throughout the
world. The recent literature on economic growth emphasizes the
importance of an expanding common pool of ideas in increasing growth
rates in all countries. As new trade and investment agreements are
negotiated to strengthen global intellectual property rights, these
transfers of knowledge can proceed without destroying the incentive to
innovate or sacrificing the profitability of innovating firms. FDI is
frequently shown to be an important vehicle for increasing
productivity in host countries, in some cases contributing relatively
more to growth than does domestic investment. Although developing
countries that now employ outdated technologies may have the most to
gain from new ideas brought in by foreign multinationals, they are not
the only beneficiaries. The resurgent competitiveness of the U.S.
automotive industry in the 1990s is often attributed in part to the
adoption of just-in-time inventory practices used successfully by
Japanese production facilities located in the United States.

Benefits to the Home Country

It might seem natural that foreign investment helps foreigners, but
what is less apparent is that the activities of multinationals can
promote growth in their home countries as well (see Box 7-5). By
developing and expanding foreign markets, multinationals provide an
important benefit to the home country, because growth in a country's
trade partners means growth in its export opportunities. And in many
cases, as firms expand their operations overseas, they expand their
management and support operations at home also, increasing employment
both at home and abroad.

Moreover, multinationals create trade by moving goods and services
between parents and their foreign affiliates. As already noted, this
intrafirm trade now plays a significant role in total U.S. trade.
Although the move from arm's-length to intrafirm transactions need not
represent ``new'' trade, evidence suggests that FDI is likely to
increase trade. This can be considered a benefit in itself, by
promoting the interchange of goods. FDI often plays an important role
in promoting trade when barriers to traditional exports exist. A
recent study shows that, in 1992, 70 percent of U.S. exports to Japan
were intrafirm exports, as were 74 percent of exports to Switzerland
and 64 percent to Russia. By contrast, only 12 percent of U.S. exports
to Taiwan, our seventh-largest foreign market, were intrafirm exports.

Arguably, intrafirm trade might not be beneficial if it represents the
foreign outsourcing of goods for production and reexport to the home
country. If this were the case, we might expect to see an intrafirm
trade deficit equal to the amount of value added overseas. But U.S.
intrafirm trade is in surplus: U.S. multinationals export more to
their overseas affiliates than they import from them. This suggests
that, on balance, shipments to foreign affiliates represent goods to
be sold in the overseas market (perhaps after final assembly there)
rather than outsourcing for reexport. In a rapidly changing world
environment, firms hoping to enter foreign markets are increasingly
coming to realize that establishing a direct presence in those markets
may be the best way to compete.

CURRENT U.S. INITIATIVES IN INVESTMENT POLICY

Evidence has shown that a stable policy environment is a good
determinant of the amount of FDI a country attracts. Countries that
are prone to nationalization, corruption, and political instability
are less likely to receive foreign investment, whereas those that
protect foreign investors and intellectual property rights do better.
This suggests that there are benefits to achieving multilateral
standards for investment rules.

Under the auspices of the OECD, the United States has joined other
countries in negotiations toward a Multilateral Agreement on
Investment (MAI) that will set ``high standards for the liberalization
of investment regimes and investment protectionï¿½with effective dispute
settlement procedures.'' The goal is to eliminate discrimination in
investment by achieving a uniform set of rules for all signatories,
thereby removing market distortions and facilitating the investment
process.

The MAI is being negotiated principally among the 29 OECD countries
that account for the vast majority of worldwide FDI flows. But the MAI
is being designed as a free-standing international treaty to which
other nations may accede. Even though the negotiations are primarily
among similar countries with similar objectives, the negotiations have
been difficult at times.

Meanwhile over 1,000 bilateral investment treaties already exist,
primarily between developed and developing countries. The United
States has signed 40 such treaties to date (Box 7-6). With these
treaties the United States has been able to establish deeper
agreements more quickly with more countries than it could by
negotiating a single agreement with a large number of countries.

Another recent initiative in which the United States has been active
is the international effort to combat corruption. Corruption is a
particularly thorny problem for multinationals in many developing
countries, and its presence may offset much of the benefit to
multinationals of locating in those countries. One recent study
estimated that the effects of corruption were equivalent to an
increase in the marginal tax rate for foreign investors of as much as
21 percentage points. Given the benefits of FDI to both home and host
countries, this strong disincentive to investment is likely to reduce
the welfare of both. It has also had important legal ramifications for
U.S. investors abroad, who are prohibited under the Foreign Corrupt
Practices Act from bribing foreign officials. This legislation has
made it even more difficult for U.S. multinationals to establish and
maintain businesses in countries with pervasive corruption.

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Box 7-6._Bilateral Investment Treaties

For much of the last decade the United States has been actively
pursuing the negotiation of bilateral investment treaties with
emerging-market countries around the world. The U.S. government places
priority on negotiating such treaties with countries undergoing
economic reform where it believes the United States can have a
significant impact on the adoption of liberal policies on the
treatment of FDI. The structure of these treaties has also laid the
policy groundwork for broader multicountry initiatives in the OECD
(the MAI) and eventually the WTO. The structure of our bilateral
investment treaties provides U.S. investors with the following six
basic guarantees:

 treatment that is as favorable as that received by their
competitors_this implies the better of national or most-favored-nation
treatment

 clear limits on the expropriation of investments, and fair
compensation when expropriation does occur

 the right to transfer all funds related to an investment into and
out of the country without delay, at the market rate of exchange

 limits on the ability of the host government to impose
inefficient and trade-distorting performance requirements

 the right to submit an investment dispute with the host
government to international arbitration

 the right of U.S. investors to engage the top managerial
personnel of their choice, regardless of nationality.

In cases where national treatment is the binding standard, the treaty
ensures that U.S. investors are treated in a manner equivalent to
domestic investors; where it is most-favored-nation treatment, U.S.
investors are assured treatment no worse than investors from any third
country receive. To date, the United States has successfully
negotiated bilateral investment treaties with some 40 countries (Table
7-4) and is actively engaged in pursuing a multilateral version of the
treaty under the auspices of the OECD.



TABLE 7-4.~--Countries with Which the United States Has
Bilateral Investment Treaties
------------------------------------------------------------------------------
~  Country and date   Country and date      Country and date   Country and date
------------------------------------------------------------------------------
Albania.....pending  Croatia......pending  Jordan.....pending  Romania....1994
Argentina......1994  Czech Republic..1992  Kazakhstan....1994  Russia..pending
Armenia........1996  Ecuador.......~..1997  Kyrgyzstan....1994  Senegal....1990
Azerbaijan..pending  Egypt...........1992  Latvia........1996  Slovakia...1992
Bangladesh.....1989  Estonia.........1997  Moldova.......1994  Sri Lanka..1993

Belarus.....pending  Georgia.........1997  Mongolia......1997  Trinidad and
Tobago.....1996
Bulgaria.......1994  Grenada.........1989  Morocco.......1991  Tunisia....1993
Camerr~on.......1989  Haiti........pending  Nicaragua..pending  Turkey.....1990
Congo
(Brazzaville) 1994  Honduras.....pending  Panama........1991  Ukraine....1996
Congo
(Kinshasha)...1989  Jamaica.........1997  Poland........1994
Uzbekistan..pending
------------------------------------------------------------------------------
Note.--Years are those when the treaty entered into force.
Source: Office of the U.S. Trade Representative.


In late 1997 the member countries of the OECD finalized a draft
treaty to outlaw bribery of foreign public officials. Holding
multinationals of all nationalities to similar standards will put
pressure on foreign officials to abide by legal and transparent
procedures in doing business with foreign companies, rather than allow
them to promote a ``race to the ethical bottom'' among companies seeking
government contracts or licensing. It is hoped that, together with the
establishment of a common set of investment rules in the MAI, the
reduction of corruption abroad will act as an incentive to FDI,
bringing increased benefits to both home and host countries worldwide.

CONCLUSION

Economies that are open to international trade and investment are more
likely to experience a rising standard of living than are economies
with significant barriers to cross-border economic activities.
Consumers in open economies benefit from a wider variety of goods at
lower prices than do consumers in economies that resist competition
from foreign suppliers. The economy as a whole benefits from an
increased ability to devote its scarce resources to economic
activities that it performs relatively efficiently. Over time, through
both international trade and international investment, open economies
benefit from higher rates of productivity growth and innovation that
result from increased participation in international markets.

Many, however, fear that international transactions will disadvantage
certain segments of the economy. As this chapter has shown, it is
difficult to associate cross-border interactions with declining real
wages of workers, or even of particular groups of workers. Indeed,
there is evidence that adjustments resulting from growth in
international trade have the potential to make workers better off. In
the United States, jobs with exporting firms pay between 5 percent and
10 percent more than do jobs in other sectors of the economy. At the
same time, the Administration recognizes that the transition from one
job to another is not always easy and that assistance must be provided
to those most affected by displacement.

As the United States is already among the most open economies in the
world, the Administration's activities have been directed toward
opening foreign markets to imports not only from the United States but
from other exporters as well. This goal has been actively and
successfully pursued in multilateral, regional, and bilateral forums.
Partly reflecting these pursuits, U.S. imports and exports have
increased significantly since 1993. Although much has been
accomplished, the Administration maintains an active international
policy agenda promoting free trade throughout the Americas, across the
Pacific, and around the world.